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The Tax Cuts and Jobs Act (TCJA) eliminated recharacterizations of Roth IRA conversions made in 2018 or later, as while Roth recharacterizations were originally created as a means to “undo” a Roth conversion for someone who later discovered they were over the conversion income limits (which were in place until repealed in 2010), in recent years they were increasingly used as a proactive strategy to increase the value of Roth conversions… and thus became perceived as an “abuse” and “loophole” that Congress felt the need to crack down on. Nonetheless, while Roth recharacterizations are now gone, it doesn’t change the fact that Roth conversions themselves can still be effective tax planning tools for helping clients reduce their long-term tax liabilities. However, the elimination of the Roth recharacterization changes the optimal timing and execution of Roth conversions going forward!

In this guest post, Jeffrey Levine of BluePrint Wealth Alliance shares some Roth conversion planning strategies and considerations after the TCJA, including the even greater importance of due diligence before completing Roth conversions, a potential shift in the best time of year to complete Roth conversions, and new best-practices strategies like Roth IRA conversion-cost-averaging, and Roth IRA conversion “barbelling”.

Notably, recharacterizations of Roth contributions are still permitted, so clients who contribute to a Roth but end up with income above the contribution limit can still change their Roth contribution back to a traditional IRA contribution… but recharacterizations of conversions that happen in 2018 and beyond are no longer permitted (though prior-year 2017 conversions can still be recharacterized until October 15th of 2018).

The elimination of all recharacterizations of conversions puts even greater emphasis on getting a conversion right the first time, as the most common reasons for wanting to complete a recharacterization (e.g., market decline, client income was higher than expected, or a client simply changing their mind) could result in considerable client dissatisfaction if a conversion isn’t done right the first time (or if the client doesn’t understand the implications of new changes). Further, less commonly noted implications of Roth conversions, such as the potential to increase Medicare Part B and Part D premiums, should not be overlooked!

In the past, completing Roth conversions as early as possible in the year was generally ideal, as a means to both maximizing the time available to consider a recharacterization, and because of the general trend for markets tend to go up more than they go down (which meant it was best to get the dollars into the Roth as early as possible so that growth would happen inside the tax-free account). Now, however, the inability to undo Roth conversions (including partial recharacterizations of an excess conversion) means it will often be more effective to implement conversions towards the end of the year, when income (and deductions) can be projected more accurately with greater confidence. More generally, clients may now want to consider various Roth conversion timing strategies, as Roth IRA conversion-cost-averaging (to diversify conversion timing risk), Roth IRA conversion “barbelling” (to balance both growth potential and over-conversion risk), in addition to simply still making a full conversion as soon as possible (to maximize Roth growth potential), or just waiting until the end of the year for all of it (to be safe).

Ultimately, the key point is to acknowledge that Roth conversion strategies are still useful after the TCJA. Although many popular Roth conversion strategies are no longer viable after the elimination of the recharacterization of Roth conversions, the attractiveness of recently reduced tax rates arguably makes Roth conversions even more appealing… with the caveat that it’s more important than ever to consider the timing!Read More…

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Executives and small business owners often struggle to figure out how to diversify a concentrated investment in company stock, due to the adverse tax ramifications of liquidating a highly appreciated investment. Which leads to strategies including variable prepaid forward contractors, exchange funds or stock protection funds to facilitate diversification, or leveraging available tax laws like Net Unrealized Appreciation to mitigate the tax consequences.

But after nearly 9 years of a bull market since the bottom in March 2009, “most” long-term investors now have substantial capital gains. Not because they held a concentrated stock investment that grew, but simply because even a diversified portfolio of mutual funds and/or ETFs may be up 100%, 200%, or even 300% since the bottom. And ironically, the more tax-efficient and “tax-managed” the fund or advisor has been all along, the less turnover there’s been, and the more likely it is to have very substantial embedded capital gains now!

And unfortunately, such large embedded capital gains create real tax complications for engaging in even routine investment adjustments like periodic rebalancing, and especially in situations where the advisor might want to switch strategies (or the investor might want to switch advisors), but “cannot” do so because of the adverse tax consequences.

On the plus side, the reality is that the tax benefits of deferring capital gains are often smaller than most investors realize, as they confuse “tax avoidance” (not recognizing the capital gains) with what really is just tax deferral (the capital gains will ultimately have to be paid if the investor is ever going to use the money).

In addition, relatively straightforward tax strategies can further help investors to get comfortable with unwinding investments with large capital gains, from establishing a “capital gains budget” for the amount of capital gains to be triggered each year (perhaps targeted to stay under the threshold for the next capital gains tax bracket), setting targets for staged sales at progressively higher (or lower) prices to help investors pre-commit to making a change, or simply engaging in a “donate-and-replace” strategy that leverages the tax preferences of contributing appreciated securities for a tax deduction (and eliminating the capital gains altogether) and then replacing the investment (as a new higher cost basis) with the cash that would have been donated in the first place!

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The annual requirement of all Americans to pay taxes on their income requires first calculating what their “income” is in the first place. In the context of businesses, the equation of “revenue minus expenses” is fairly straightforward, but for individuals – who are not allowed to deduct “personal” expenses – the process of determining what is, and is not, a deductible expense is more complex.

Fortunately, the basic principle that income should be reduced by expenses associated with that income continues to hold true, and is codified in the form of Internal Revenue Code Section 212, that permits individuals to deduct any expenses associated with the production of income, or the management of such property – including fees for investment advice.

However, the recent Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct Section 212 expenses, as a part of “temporarily” suspending all miscellaneous itemized deductions through 2025. Even though the reality is that investment expenses subtracted directly from an investment holding – such as the expense ratio of a mutual fund or ETF – remain implicitly a pre-tax payment (as it’s subtracted directly from income before the remainder is distributed to shareholders in the first place).

The end result is that under current law, payments to advisors who are compensated via commissions can be made on a pre-tax basis, but paying advisory fees to advisors are not tax deductible… which is especially awkward and ironic given the current legislative and regulatory push towards more fee-based advice!

Fortunately, to the extent this is an “unintended consequence” of the TCJA legislation – in which Section 212 deductions for advisory fees were simply caught up amidst dozens of other miscellaneous itemized deductions that were suspended – it’s possible that Congress will ultimately intervene to restore the deduction (and more generally, to restore parity between commission- and fee-based compensation models for advisors).

In the meantime, though, some advisors may even consider switching clients to commission-based accounts for more favorable tax treatment, and larger firms may want to explore institutionalizing their investment models and strategies into a proprietary mutual fund or ETF to preserve pre-tax treatment for clients (by collecting the firm’s advisory fee on a pre-tax basis via the expense ratio of the fund, rather than billed to clients directly). And at a minimum, advisory firms will likely want to maximize billing traditional IRA advisory fees directly to those accounts, where feasible, as a payment from an IRA (or other traditional employer retirement plan) is implicitly “tax-deductible” when it is made from a pre-tax account in the first place.

The bottom line, though, is simply to recognize that, while unintended, the tax treatment of advisory fees is now substantially different than it is for advisors compensated via commissions. And while some workarounds do remain, at least in limited situations, the irony is that tax planning for advisory fees has itself become a compelling tax planning strategy for financial advisors!

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In today’s contentious legislative environment in Washington, it’s not often that Congress passes any legislation. Which means when a bill actually is on track to be approved, various members of Congress often tack on a number of other provisions that they wish to see approved as well (either individually, or as part of the negotiated process for a compromise to pass the overall legislation).

Thus was the path of the recent Bipartisan Budget Act of 2018 (H.R. 1892), which was passed into law by President Trump on Friday, February 9th. As while it was intended primarily as the legislation that would avoid a government shutdown by agreeing to increase government spending limits and raising the debt ceiling for two years, buried in the legislation were a number of tax-related provisions – some temporary, and others permanent – with impact for both high-income and low-income households.

Of primary note for financial advisors who work with higher-income individuals is that, starting in 2019, there will be a new IRMAA tier for Medicare Part B premium surcharges for individuals earning more than $500,000 (or married couples with AGI in excess of $750,000), stacked on top of what were additional adjustments to the Medicare premium surcharge tiers that just took effect in 2018 as well!

Also included in the legislation were a number of temporary-but-immediate retroactive reinstatements of popular tax provisions for 2017, including the above-the-line education deduction (for those who weren’t already fully eligible for the American Opportunity or Lifetime Learning Tax Credits), the deductibility of mortgage insurance premiums, and relief from any cancellation-of-debt income for those who go through a short sale with an underwater mortgage on their primary residence.

In addition, the Bipartisan Budget Act of 2018 also provides a number of changes to grant more flexibility for hardship distributions from employer retirement plans, authorizes the creation of a new Form 1040SR (an “E-Z” tax filing form for seniors), and provides a number of retirement-plan-related and other tax relief provisions for those who were impacted by the California wildfires in late 2017!

Which means even though the Bipartisan Budget Act of 2018 was nominally “budget legislation” and not a tax law, a number of households may be impacted by its tax-related changes!

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It’s long been a tenet of taxation that when a group of individuals come together for a “joint venture”, the taxation of their collective business should simply be done by taxing each individual on their respective share of the business. Over the years, this has been formalized into the structure of “pass-through” business entities, from partnerships to LLCs to S corporations (and of course, the sole proprietor themselves)… all of which simply subjected the business’s income to the tax rates of their individual shareholders.

Until the Tax Cuts and Jobs Act (TCJA) of 2017, which for the first time has introduced a so-called “Qualified Business Income” (QBI) deduction for pass-through entities that will effectively permit pass-through businesses to be taxed on only 80% of their income. To some extent, the introduction of this new QBI deduction was necessary to keep pass-through business tax rates reasonably in line with corporate tax rates (which were also reduced to 21% under TCJA) when stacked on top of qualified dividend or long-term capital gains tax rates. Yet at the same time, the new QBI deduction also introduces a substantial tax planning opportunity… and some complexity, too.

The core of the qualified pass-through business income deduction is that shareholders will simply be permitted to deduct 20% of the business income against itself, which will be claimed as a below-the-line (but not itemized) deduction for tax purposes. However, to prevent abuse – especially at higher income levels – the new QBI rules do not permit the deduction for high-income “Specified Service” businesses (including lawyers, accountants, doctors, consultants, and financial advisors), and high-income individuals may also have their QBI deduction limited if they do not employ a substantial number of people relative to the size of the business (under a new “W-2 wages” limit), or invest into a substantial amount of property (under the “wages-and-property” limit).

The end result of these rules is that small businesses should have relative ease claiming at least a modest new QBI deduction, which is available even if they’re simply a sole proprietor (i.e., it’s not necessary to literally create a pass-through business entity like a partnership, LLC, or S corporation). And large highly scaled businesses may enjoy an even greater deduction. However, businesses that rely primarily on the efforts of their owners – whether overtly as Specified Service businesses, or simply those with a limited amount of employee or capital investments – may still struggle to take advantage of the new QBI rules, especially those over the new income thresholds of $157,500 for individuals, and $315,000 for married couples!

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Most taxpayers are eager to claim any and all tax deductions that they can, yet the reality is that with the newly expanded Standard Deduction under the Tax Cuts and Jobs Act (TCJA) of 2017, as many as 90% of households will no longer itemized deductions at all… which effectively means many tax deductions that were recently popular, from state and local income and property taxes, to mortgage interest, and even charitable contributions, may actually be worthless in the future.

For those who are at least close to the threshold where itemized deductions exceed the Standard Deduction, though, it may be appealing to deliberately time and “lump together” available itemized deductions (e.g., shifting the timing of state estimated tax payments, and property taxes where permitted), or even clump charitable contributions into a donor-advised fund, such that the combined lumped-and-clumped deductions do exceed the Standard Deduction… at least every few years.

Ironically, those who already have substantial itemized tax deductions – especially including the mortgage interest deduction – may already have more than enough deductions to pursue such strategies. And with the new $10,000 cap on SALT (State And Local Tax) deductions, many households will struggle to itemize at all (especially married couples). Nonetheless, for some, the opportunity to lump and clump deductions together – especially for those that have other (appreciated) assets available to front-load charitable contributions into a donor-advised fund (and save on capital gains taxes in the process) – can produce a material tax savings in the future!

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The “American Dream” has long included the opportunity to own your own home, which the Federal government incentivizes and partially subsidizes by offering a tax deduction for mortgage interest. To the extent that the taxpayer itemizes their deductions – for which the mortgage interest deduction itself often pushes them over the line to itemize – the mortgage interest is deductible as well.

Since the Tax Reform Act of 1986, the mortgage deduction had a limit of only deducting the interest on the first $1,000,000 of debt principal that was used to acquire, build, or substantially improve the primary residence (and was secured by that residence). Interest on any additional mortgage debt, or debt proceeds that were used for any other purpose, was only deductible for the next $100,000 of debt principal (and not deductible at all for AMT purposes).

Under the Tax Cuts and Jobs Act of 2017, though, the debt limit on deductibility for acquisition indebtedness is reduced to just $750,000 (albeit grandfathered for existing mortgages under the old higher $1M limit), and interest on home equity indebtedness is no longer deductible at all starting in 2018.

Notably, though, the determination of what is “acquisition indebtedness” – which remains deductible in 2018 and beyond – is based not on how the loan is structured or what the bank (or mortgage servicer) calls it, but how the mortgage proceeds were actually used. To the extent they were used to acquire, build, or substantially improve the primary residence that secures the loan, it is acquisition indebtedness – even in the form of a HELOC or home equity loan. On the other hand, even a “traditional” 30-year mortgage may not be fully deductible interest if it is a cash-out refinance and the cashed out portion was used for other purposes.

Unfortunately, the existing Form 1098 reporting does not even track how much is acquisition indebtedness versus not – despite the fact that only acquisition mortgage debt is now deductible. Nonetheless, taxpayers are still responsible for determining how much is (and isn’t) deductible for tax purposes. Which means actually tracking (and keeping records of) how mortgage proceeds are/were used when the borrowisecong occurred, and how the remaining principal has been amortized with principal payments over time!

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Major tax reform typically only occurs once every decade or few. But after a tumultuous series of negotiations in both the House and Senate, a final reconciled version of the Tax Cuts and Jobs Act of 2017 appears to be heading shortly to President Trump for signature.

The legislation will result in substantive tax reform for corporations, with the elimination of the AMT and consolidation down to a single 21% tax rate, all of which are permanent. However, when it comes to individuals, the new legislation is more of a series of cuts and tweaks, which arguably introduce more tax planning complexity for many, and will be subject to a(nother) infamous sunset provision after the year 2025.

Nonetheless, the new tax laws have a lot to like for individual households, almost all of whom will see a reduction of taxes in the coming years (though not after the 2025 sunset). While 7 tax brackets remain, most are decreased by a few percentage points (to a top rate of 37%), along with the repeal of the Pease limitation. The AMT remains, but its exemption is widened. Most common deductions remain, though they are more limited, and an expanded standard deduction means fewer will likely claim itemized deductions at all in the future. There is a new crackdown on the Kiddie Tax (subjected to trust tax rates instead of parents’ tax rates), but a much wider range of families will benefit from a great expanded Child Tax Credit (with drastically higher income phaseouts). And a doubling of the estate tax exemption amount – to $11.2M for individuals, and $22.4M for couples with portability, will make estate tax planning irrelevant in 2018 and beyond for all but the wealthiest of ultra-HNW clients.

Of particular interest for financial advisors are a number of key provisions. The controversial rule that would have eliminated individual lot identification, and required all investors to use FIFO accounting, is out and not included in the final legislation. However, also out is the ability to deduct any miscellaneous itemized deductions subject to the 2% of AGI floor – which means all investment advisory fees will no longer be deductible starting in 2018. In addition, several popular Roth strategies will be curtailed by the repeal of recharacterizations of Roth conversions (although the backdoor Roth rules remain). And while the deduction for pass-through businesses remains in place in the final legislation, and may be appealing for “smaller” advisors whose total income is under the $157,500 for individuals (and $315,000 for married couples) threshold. Although for larger advisory firms, the service business treatment is so unappealing, that large RIAs may soon all convert to C corporations (or at least, become LLCs and partnerships taxed as corporations under the “Check The Box” rules).

Ultimately, the new tax rules are actually complex enough that it will likely take months or even years for all of the new tax strategies to emerge, from when it will (or won’t) make sense to convert to a pass-through business, to navigating the new tax brackets, and the emergence of strategies like “charitable lumping” to navigate a higher standard deduction. In the near term, though, most are simply focused on taking advantage of end-of-year tax planning… especially taking advantage of deductions in the next two weeks that may not be available after 2017 once the Tax Cuts and Jobs Act is signed into law.

On the “plus” side, though, at least ongoing tax complexity means there will continue to be value for tax planning advice?

A key aspect of proposed tax reforms, ever since President Trump was on the campaign trail, was the possibility of reducing the tax rate on pass-through business entities like S corporations, LLCs, and partnerships. To some, the tax break was intended as an incentive for small business growth. For others, it was viewed as a necessity when proposed corporate tax reform and lower tax rates for C corporations would effectively put pass-through entities at a disadvantage without a similar break. Either way, there has been substantial momentum on the proposal, which was codified in both the House and Senate versions of the Tax Cuts and Jobs Act.

However, a key caveat of creating favorable treatment for pass-through businesses is to not unwittingly convert personal labor income – i.e., wages or self-employment income – into pass-through income eligible for favorable rates. Which at the least can distort the relative incentives of being an employee (paid as wages) versus self-employed (paid through a pass-through business entity). And at worst could incentivize employees to literally quit their jobs and try to get rehired as independent consultants – and paid through shell pass-through businesses – just to obtain favorable rates.

As a result, both the House and Senate proposals under the Tax Cuts and Jobs Act would limit the availability of the pass-through for so-called “service businesses”, either by eliminating the favorable rates for those who are “active participants” in a pass-through service business (in the House version), or simply eliminating the preferential treatment altogether for pass-through service businesses (in the Senate version).

Yet in practice, the actual mechanisms that both the House and Senate have created impose substantial economic burdens on large service businesses. Founder/employees of large service businesses (e.g., with $10M+ of employment income) can actually face marginal tax rates of 100%, 200%, or more on their wages as a leader of the firm, because their employment in their firm converts all their non-wage business income into less-favored ordinary income (under the House proposal). Large service businesses that want to scale may struggle to attract capital if their profits are literally “less valuable” on an after-tax basis to outside investors when all service business income is taxed less favorably (under the Senate proposal). And service businesses that also have non-service business lines will find their non-service income (otherwise eligible for favorable rates) becoming “tainted” by being wrapped under a service business.

Which means ultimately, if the goal is to reasonably separate “labor income” from “capital income” without distorting large service businesses, it’s necessary to adapt the rules further. One option is to simply codify a requirement that in service businesses, “reasonable compensation” must be paid (and taxed as wages), with only the excess eligible for favorable pass-through treatment (perhaps with a safe harbor to stipulate that any excess above a certain level of income is automatically eligible for pass-through treatment). Or alternatively, Congress could actually designate a “qualifying large service business” (e.g., with at least $10M of revenue and 30+ employees) that is automatically deemed to qualify its business income as favorable pass-through income (as such businesses typically already have governance mechanisms in place to ensure owner-employees are paid properly as owners for their labor, and separately for their pass-through business profits).

Without some solution, though, service businesses face substantial disadvantages in attracting capital, and/or outright disincentives for founders to continue to work – potentially with marginal tax rates in excess of 100%! Or alternatively, the current proposals may simply drive large service businesses to all recharacterize themselves as C corporations, in a world where the corporate tax rate would be dramatically lower (and even if the firm was deemed a Personal Service Corporation, would be taxed more favorably than a pass-through service business if top corporate tax rates are only 20%). Which would then disadvantage any service businesses that couldn’t effectively reorganize as a C corporation.

The bottom line, though, is simply to recognize that while it’s an important matter of tax policy to tax labor income as labor income, and business income as business income… the reality is that in large service businesses, the profits of the business are substantially attributable to investments in capital (albeit human capital), and not just the fruits of an owner-employee’s personal labor. Good tax policy must recognize that difference.

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The benefit of contributing to pre-tax retirement accounts like IRAs and 401(k) plans is the opportunity to receive an upfront tax deduction, and enjoy the growth that remains tax-deferred as long as the investments remain in the retirement account. For those accumulating towards retirement, this provides additional tax-deferred compounding growth that can help bridge the gap towards retirement itself. With the expectation that once someone reaches retirement, they will begin to take distributions – and Uncle Sam will finally get his share of the tax-deferred account.

To ensure this final outcome, the Internal Revenue Code requires that retirement account owners begin liquidating their accounts upon reaching age 70 ½. Of course, for those who actually need to use their retirement account to fund their retirement lifestyle anyway, distributions will likely be occurring already. However, for those who don’t need the funds, the Required Minimum Distribution (RMD) obligation ensures that at least some money is distributed – and taxed – every year.

For those who don’t actually need to use their retirement accounts – yet, or at all – the mandatory withdrawals of the RMD obligation presents a substantial tax challenge, as the forced distributions not only trigger taxes on the RMD amount itself, but also risks driving the retiree up into a higher tax bracket when stacked on top of all of his/her other retirement income as well.

Fortunately, though, the reality is that there are numerous strategies that can be leveraged to manage and minimize required minimum distributions – both for those who have already reached the RMD phase, and also those still accumulating towards it, who want to plan ahead to minimize the bite of RMDs in the future.

Ultimately, it’s impossible to completely and indefinitely avoid the requirement to distribute retirement accounts – if only because, even to the extent the account isn’t liquidated during life, the beneficiaries will be subject to additional RMD obligations after the death of the original account owner. Nonetheless, the potential exists to at least partially manage and minimize RMDs, and mitigate some of their tax bite!